Taper Talk: A Serious Look at the Fed's Options

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Tamp, Tamper, or Taper

It doesn’t matter what you call it, and it doesn’t even matter when you call for it, the idea that the Fed may be considering scaling back its easing policies is on the table.

We have finally gotten the highly-anticipated Jon Hilsenrath article. The alleged Fed mouthpiece (I think he has been wrong more than right lately) has come out and written about possible Fed action.

It is going to take some time for the market to digest the possibilities and figure out a good estimate on the timing. The market will move long before the Fed does, so it is critical to be prepared for the possibilities.

Saying They “Could Buy More” Was a Sign That They Were Thinking of Buying Less

Our instant reaction to the FOMC was different than many. The FOMC took the time to mention that they could be buying more. Many seemed to take that as a sign that the Fed was actually considering doing more QE.

We didn’t take it that way at all. We took it as a step towards decreasing the amount of purchases. This Fed is consistent in its pursuit of policy and tends towards being careful, rational, and most importantly, methodical.

The economy has been doing well BUT not great, and there are signs that QE is distorting markets to the point that it is losing some credibility, so if anything, the Fed should be considering pulling back from purchases.

We believe the Fed added the “could increase” language ahead of an actual decrease. They want to test the waters before pulling back, while making it easy to increase again if need be. Had they taken an approach of decreasing purchases and then had to add language about buying more again, it would have made them look weak. It may have even been a two-step process -- add language, then add purchases.

This way, the Fed can now more easily increase purchases if they decrease purchases to no avail.

Rate Hikes, Treasury QE or Mortgage QE, Bank Reserve Rate

There are really four things that the Fed can do, or at least four fairly obvious things.

They could hike rates. The Fed could in theory increase the overnight Fed Funds target rate. That would cause the entire curve to shift higher. I don’t see this happening.

As soon as they start hiking rates, we would be inundated with data showing that the Fed is never “one and done”. When the Federal reserve starts to hike rates, they tend to do it over a period of time. This would create far too much financial uncertainty, and cause real concern across the entire curve. The 5-year would look silly even at 0.82% if the Fed started raising rates. There would be a shock along the front end that would cascade throughout the entire curve.
The impact would be worse because the Fed has spoken over and over about “low rates for extended periods”. In theory, 0.50% could be considered a low rate, but I think increasing short-term rates is playing with fire.

So the Fed won’t increase the short-term rate.

Mortgage QE Versus Treasury QE. They could scale back either of these programs. I think the Fed sadly got itself caught up into a suboptimal situation. Their impact in the mortgage market is bigger and more disruptive than in the Treasury market. They are buying up a huge amount of supply at levels that simply isn’t economic for non-Fed buyers. The Fed actions have pushed mortgage lenders away -- the exact opposite of their intentions. Plus, the spread between the rates on conforming mortgages versus non-conforming mortgages remains high.

The Fed has messed up the mortgage market and might be happiest to extricate themselves from thi. But there are major obstacles. They have bifurcated the mortgage market so much that it is unclear where private money will actually step in. It may also be taken as very negative by the market. So many market participants are basing bullish economic projections on continued improvements in housing that any action that threatens to stall that could seriously damage market psychology.

So while we think the Fed would like to cut back on mortgage QE, it risks hurting the market the most there.

Treasury QE is the easiest. This is the easiest place for the Fed to experiment. They can shift along the curve. The market can absorb their demand reasonably well, and can deal with less Fed demand reasonably well.

I last ran this in the middle of April. The Fed continues to dominate the long end, owning close to 40% of all Treasuries maturing in 2020 and beyond. If anything, they are already uncomfortably large holders.

The supply/demand pressures away from the Fed activity are also an issue that the Fed could help address. As tax receipts come in, the Treasury needs to issue less. And as companies do well, their pension plans need to buy more Treasuries.

So throttling back the Treasury purchases probably does the least amount of damage to the broader markets. It probably does the least amount of good, but this Fed is concerned about not doing harm, so expect the Treasury purchase program to bear the brunt of the cutbacks (if there are any).

The Bank Reserve Rate (the rate the Fed pays on deposits). This is in theory something that the Fed could cut which should have the impact of encouraging banks to shrink reserves. The Fed certainly isn’t going to pay banks more for reserves, so the only way it can go is down. That seems to be unlikely, unless somehow the Fed decides that some reduction in QE would serve as an offset, and that they can encourage banks to lend rather than “hoard”. It seems unlikely to work, as banks may choose another course of action altogether, but this rate, often off the radar screen, bears some scrutiny as it could be another tool in the Fed’s quiver, and we cannot forget that this Fed is careful, rational (even smart), and methodical.

Why Is This Bad for Treasuries?

It isn’t.

The knee-jerk reaction to the story has been to sell off Treasuries.

There are several reasons that reaction is likely to be wrong.

Hypocritical. Let’s start with the hypocrisy of the argument. Many have argued thar stocks benefit from QE more than bonds. Now they will argue why the Dow Jones Industrial Average ((INDEXDJX:.DJI) benefit more from less QE. Basically, there is a whole swath of research that pits bonds versus stocks and stocks always win.

First and foremost, bonds and stocks don’t have to move in the opposite direction. But beyond that, the argument is that the Fed is so good at timing things that the economy is now about to enter a goldilocks phase, where the “economic motor” has been jumpstarted and can now run on its own. We are far more likely to see some signs of economic weakness, followed by a fear trade, which would benefit Treasuries rather than stocks.

This is the Non-Farm Payroll report that saved the world. Are there clear and obvious signs of growth in the job market? We struggle to see it. Yes, employment has bounced up, and if you ignore that 3 of the last 4 months were below average (since October 2010), then it must be good. Seriously, I can stare at this chart for hours and have difficulty coming up with a compelling story. I don’t see a bad story in the data, but it is more wishful thinking than critical thinking that leads to the conclusion that we have seen a major reversal in the job trend.

Buying less isn’t the same as selling. The overall QE story should remain intact. The Fed isn’t going to be selling anytime soon, just buying less. The US Treasury needs to borrow less due to higher tax receipts. Pension funds need to buy more Treasuries as they continue to perform well. The Fed is just creating a little more room for those private sector flows. At 40% with a 70% limit, the Fed is already squeezing too many issues. While there will be some concerns about Treasury purchases, the QE flows affect the entire market, and I suspect the riskiest end (stocks) are more susceptible to QE fears.

Curves. Curves are steep and supportive for rates.

The2-year versus 10-year Treasury (INDEXSP:SPUSTTTR) spread is interesting. When it hit 142 bps ahead of the FOMC, we took it as a sell signal. That was a post-crisis tight. We are back to levels that are interesting. The long run-average is only 114 bps. Only brief periods have been spent at about 180 bps, and much of that was when the crisis first hit and we hadn’t accepted Japanese-style yield curves. Or less cynically, whee we still believed in quick rebounds.

We see many more scenarios that cause investors to question the wisdom of buying S&P 1,650 with a Fed considering pulling back than we do where it causes investors to buy stocks.

The converse is also true. Muddling along with a nervous Fed probably plays out in a way that makes current Treasury yields look okay.

Bond bubble but stock nirvana? Maybe this is the same as the hypocrisy argument, but I find it hard to come up with a plausible scenario that allows a large bond sell-off without an equally bad, or worse, sell-off in stocks. The Treasury bond is connected to the Investment Grade Bond, the IG bond is connected to the HY bond, the HY bond is connected to the EM bonds, and all the bonds are connected to the stock market. I am not sure which way it would cascade exactly, but if 2007 and 2008 were Credit Bubbles that crushed stocks, why would this time be different? I don’t think we are in a credit bubble, but if we are, I don’t see stocks escaping.

Where do we stand?

It is time to be very wary of risk. We will provide additional updates in the near future, but our biggest shift is out of CDS and negative high yield.

On CDS, we see the risk of the “paradox of CDS” occurring. It might be the cheapest way to play credit, but it is a hedge product, and the market won’t want to sell bonds yet. Look for CDS to underperform.

High-yield, and the high-yield ETFs like the iShares HY ETF (NYSEARCA:HYG) in particular, and even the much beloved Powershare Senior Loan Portfolio (NYSEARCA:BKLN), all strike me as very susceptible to a liquidity squeeze/mark-to-market stop loss sell-off. The fundamentals aren’t changing, but too many own paper they think is too rich, yet believe they can time their exit better than the next person.

So look for liquid credit weakness.

Perversely, that should create a nice bid for Treasuries. Yes, it is a paradox that fears of a Treasury sell-off spark the move that causes Treasuries to rally, but for those who have lived with the paradox of CDS for a long time, this should seem less strange.

This piece is a free sample from Peter Tchir's Fixed Income Report. For a two-week free trial, including access to Peter's market commentary and exclusive portfolio strategies, please click here.